MagicDiligence (< 20)

Revew of Joel Greenblatt's "The Big Secret for the Small Investor"

6

MagicDiligence put out a post last week examining some of Magic Formula Investing inventor Joel Greenblatt's interviews leading up to the release of his newest book, The Big Secret for the Small Investor. I was able to read the book over the weekend and wanted to post some of my thoughts concerning it.

First of all, like The Little Book that Beats the Market, this is a short, easy read that can easily be completed in a single sitting. The target audience is the individual investor, although I believe it is helpful to have a little knowledge of business accounting before reading this one. While The Little Book can be easily digested and understood by even the most novice investor, Big Secret assumes also that the reader has at least a basic understanding of valuation and return on capital principles.

While I originally assumed that the book was designed as a promotional piece for Formula Investing's "value weighted indexing" funds, that's not really an accurate description (in fact, those funds are never mentioned specifically in the book). Greenblatt starts off by going through a simplified example of how to value a business using discounted free cash flow (DFCF). He makes the point that, in order to follow Ben Graham's advice to buy with a margin of safety, you first have to have a value for the business in the first place! Greenblatt then shows how small assumptions in a DFCF can make huge differences in the calculated value of a company. The point: it's hard and often inaccurate to try and value a business in this manner.

Next, he briefly looks at some alternative valuation methods - comparing a firm's valuation against historical norms and competitors, doing a sum-of-parts valuation, and looking at liquidation value. While Greenblatt agrees that these can be valuable processes, he argues (correctly) that most individual investors don't have the expertise, time, or want to work these out.

These guidelines established, the book then delves into solutions to the problem for individual investors. The first he advocates is something I call the "Buffett solution": stick only to companies that have stable cash flows and predictable growth, thus making it much easier to properly guess guidelines for the different valuation techniques.

Aside from this, Greenblatt says that most investors simply want their money managed for them and don't want to deal with it. This leads into a discussion of the mutual fund industry. I thought Greenblatt did a good job of explaining why it is so difficult for mutual funds to consistently outperform the market, given their focus on attracting and keeping assets and the requirement to outperform every quarter lest clients take their cash somewhere else.

From there, he focuses on index funds. It is shown that market cap weighted index funds, like those tracking the S&P 500 or Russell 1000, consistently beat the vast majority of actively managed funds. But can an index fund do even better? Sure. He then goes on to show that an equal weighted fund (where all stocks in a fund are owned equally, instead of weighted by market cap) does even better - in a range of 1-2% annually over the long term. Fundamentally weighted indexes, where more money is put into firms that are larger on the basis of earnings, revenues, or book value, are presented as another option that outperforms the traditional market cap weighted funds.

This leads up to the money shot - Greenblatt's idea of "value weighted index" funds. This is where you take the top X number of stocks from a group (say, the largest 1,400 stocks by market cap on U.S. exchanges), rank them using value metrics (say, a combination of earnings yield and return on capital), and buy more of the ones that rank the highest. This, of course, is exactly what his new funds created through Formula Investing do.

The big question is: how did this strategy back-test? Pretty well, I must say. According to the book, from 1990-2010, the value weighted index strategy would have returned 13.9% compounded annually vs. 7.6% for the S&P 500, and 7.9% for the Russell 1000.

Overall Impressions

If I had to pigeon-hole Greenblatt's books, I would say that The Little Book is great for beginning investors who want to be active managing their money, The Big Secret is great for the "lazy" investor who wants something better than an index fund, and You Can Be a Stock Market Genius as ideal for the advanced investor looking for an edge to find individual stocks.

My favorite chapters of The Big Secret are the ones where Greenblatt goes into the areas where individual investors have clear advantages over "big money". These chapters are kind of a Stock Market Genius "lite", and if you like them too, go read that book!

In all, this was probably my least favorite of Greenblatt's 3 books, but inactive investors may disagree. It is certainly well worth the $10 price on Amazon and 2 hours of your time, regardless of your experience level in investing.